Zillow, RetailMeNot, Trulia Lead Small-Cap Internet Picks at RBC

By Tiernan Ray

RBC Capital Markets Internet analyst Mark Mahaney late Friday offered an update on the outlook for online advertising and retail stocks, predicting continued benefits to the group from trends in social, local and mobile transactions.

In conjunction with the report, Mahaney raised his ratings on shares of RetailMeNot (SALE), Zilllow (Z), Trulia (TRLA) to Outperform from Sector Perform, and raises his price target on Zillow to $100 from $90.

Mahaney commences by reviewing the outperformance of large-cap Internet names in 2013, led by Netflix (NFLX), Twitter (TWTR), and Groupon (GRPN), while eBay (EBAY) and Expedia (EXPE) underperformed:

2013 was a very strong year of returns for large cap Internet stocks, more than doubling the average returns of a very strong 2012. The market in general performed very well, with the S&P 500 and the NASDAQ capturing 30% and 35% yearly returns, respectively, but, nonetheless, 10 of our 12 large cap Internet stocks managed to meaningfully outperform these benchmarks. The top three outperformers in the group were NFLX, GRPN, and TWTR, which each returned more than 100% in 2013 (TWTR just since its November 6th IPO). Only two of our large cap stocks (EBAY and EXPE) materially underperformed the market, and they are both still clinging to positive gains. In many ways, this was a year of turnarounds, as GRPN was the group’s single-biggest underperformer from 2012 and EXPE was the biggest outperformer in 2012. There may be something to a reversion-to-the-mean stock-picking strategy…

For 2014, we are modeling a 6% increase in total Global Advertising and ~200bps of increased Online penetration. We think that SoLoMoVo (Social, Local, Mobile, and Video) continues to be a major driver of Online Advertising growth. Mobile has become especially powerful as a growth factor now that it has reached a point of materiality (i.e., 10%+ channel) for all major Internet companies. Our outlook calls for $133B of Global Online spend in 2014, up 16% Y/Y and accounting for 25% of total Global Advertising.

The same is the case for faster growth in online retail in 2014:

For 2013, we expect that Global Online Retail spend reached $768B, growing 25% Y/Y and accounting for 4% of total Global Retail spend. For 2014, we are modeling a 5% Y/Y increase in Global Retail spend and ~60bps of increased Online penetration. We think that the continued expedition of delivery times and the incremental impact of Mobile devices will continue to be drivers in 2014. We are forecasting Global Online Retail spend of $921B in 2014, up 20% Y/Y and accounting for 5% of total Global Retail spend.

Underlying the growth in all areas is more and more usage of mobile computing devices, whose significance he refers to as “mobile materiality”:

Although companies’ disclosure of Mobile materiality is not consistent across Internet companies, we put together some of the most important datapoints from the companies we see as Mobile leaders. Advertising models are leading the way. In terms of Mobile revenue generation (likely the most important Mobile statistic), Pandora, Twitter, and Facebook will each likely generate 50% or more of their Ad revenue in 2014 from Mobile devices. We give honorable mentions for Yelp, which sees 60% of searches on Mobile devices and Zillow, which has disclosed that 60% of usage on the site is via Mobile devices (TRLA sees similarly high Mobile usage). The most impressive Mobile stats from non-advertising business models are the 27% of Orbitz Hotel Bookings that come via Mobile devices and the 24% of GMV that eBay generates via Mobile.

Regarding Zillow, Mahaney’s upgrade is based on the view that “Zillow is one of the best small-cap plays on two of our 2014 Internet Growth factors: Mobile Materiality and Local Internet Adoption.”

And he outlines three factors he finds commendable:

1) Very Robust Growth Outlook – In the last quarter, Zillow added a record number of agent subscribers and maintained Y/Y growth rates near 70%. Unique Users (the top of the funnel) accelerated to near 70% growth rates; 2) New Revenue Lines – Zillow now generates a material portion of its overall revenue (>10%) from its Mortgage Marketplace, which is growing more than 100% Y/Y and has also begun to monetize Rentals…Home Improvement is next; and 3) Demonstrated Margin Potential with Offensive Investments – Unlike some of our other high growth small cap names, Zillow has already demonstrated the ability to drive EBITDA margin leverage. The company saw margins as high as 24% before beginning to aggressively invest in Offline advertising. We view this as an offensive move that will help Zillow capture brand whitespace in Online Real Estate. Also, we think the potential for margin leverage in 2014 could create and EBITDA growth inflection point.

RetailMeNot is also one of the best small caps for mobile materiality and local Internet, he writes. Again, he has a handful of characteristics he highlights:

Lastly, Trulia exhibits exposure to the same two important trends, although it is not the leader that Zillow is, and it has challenges:

Trulia does continue to face some business challenges, including the integration of the very big Market Leader acquisition and the buildout of adjacent revenue streams such as Mortgages and Rentals, but we think these risks are likely more than accounted for by the current valuation gap. Our Trulia estimates imply an 89% EBITDA CAGR between 2013 and 2016, as the company has the opportunity to grow its top line at a very fast rate and to see meaningful EBITDA margin expansion. This growth rate warrants a premium multiple, in our view. Our $54 price target is the result of a 30x EV/EBITDA multiple on our 2015 estimates. We are tweaking our estimates just slightly for a post-Q3 adjustment the company made to its tax liability as well as the recent convertible notes offering.

About Tech Trader Daily

Tech Trader Daily is a blog on technology investing written by Barron’s veteran Tiernan Ray. The blog provides news, analysis and original reporting on events important to investors in software, hardware, the Internet, telecommunications and related fields. Comments and tips can be sent to: techtraderdaily@barrons.com.